Market Microstructure and Exchanges



Market Microstructure and Exchanges

Chapter for World Federation of Exchanges

50th Anniversary Commemorative Book

Larry Harris

USC Marshall School of Business

Draft: December 25, 2009

Introduction

During the last 50 years, academic research into trading and exchanges has advanced substantially. Researchers have carefully considered the determinants of transaction costs; the role of information in the markets; how trading rules affect liquidity, price efficiency, and volatility; the competition among exchanges, brokers, and dealers; and how best to regulate the markets. This chapter provides a brief overview of insights into trading processes that have come out of the academic literature.

Many of the perspectives presented in this chapter are familiar to practitioners who often are not consciously aware of them. Indeed, much of what academics know about the markets has come from practitioners who generously shared their practical knowledge with academics. Academics took this knowledge and organized it to help people recognize and better understand the issues important to them. The resulting body of knowledge provides a “big picture” that helps practitioners make better trading decisions and helps exchanges and regulators better understand how to organize and oversee trading.

The discussions in this chapter present the essentials of this knowledge. To ensure that the presentation reads easily, the text discusses only the principles and not also the history of each contribution. Readers who wish to learn more should consider reading my introductory text, Trading and Exchanges: Market Microstructure for Practitioners. For excellent surveys of theoretical and empirical studies in market microstructure, readers also may consider consulting Maureen O’Hara’ book, Market Microstructure Theory and Joel Hasbrouck’s book, Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading.

Practitioners and academics are very interested in various dimensions of market quality, the most important of which are liquidity, price efficiency, and volatility. Liquidity refers to the cost of trading. Markets are liquid when traders can easily arrange a trade without affecting prices much. Price efficiency refers to the extent to which prices reflect information about fundamental security values. Prices are efficient when traders cannot use publicly available information to predict future price changes. Volatility refers to the rates at which prices change. Prices are volatile when fundamental values change quickly, when traders trade foolishly, or when exchange mechanisms do not work well.

Market quality depends on primarily on traders. Traders make markets liquid when they allow other traders to trade. They make prices efficient when they trade securities based on analyses of information that they conduct. They may make prices excessively volatile if their demands to trade become excessive. Accordingly, our discussion starts with an identification of the major reasons why traders trade.

Market structure—how exchanges, brokers, and dealers arrange trades—helps determine market quality by shaping the opportunities and incentives that different types of traders face. The second half of this chapter describes how different market structures affect market quality.

Traders

Economists identify three broad groups of traders when describing the origins of various market quality dimensions: Utilitarian traders, informed traders, and dealers. Utilitarian traders trade because they expect to obtain some benefit besides trading profits from their trades. Informed traders trade to profit from accurate predictions of future prices. Dealers profit by selling liquidity to other traders. Although people trade for many different reasons—and often for more than one reason at a time, these three types of traders represent most trading strategies.

1 Utilitarian traders

Utilitarian traders include many different types of traders whose trading generally is unrelated to fundamental security values. The best known utilitarian traders are investors and borrowers who trade to move money from the present to the future or vice versa. Other utilitarian traders include hedgers who trade to offset or insure against risks that they scare them; gamblers who trade for entertainment; tax avoiders who arrange trades to lower or defer their taxes; and asset exchangers who exchange one asset for another that is of greater immediate value to them.

In each of these cases, the traders trade because they hope to obtain some benefit from trading besides trading profit. Investors and borrowers move money through time. Hedgers reduce their net risk exposure. Gamblers obtain entertainment. Tax avoiders lower the present value of their tax liabilities, and asset exchangers obtain assets of greater immediate value to them. In all cases, these traders would like to profit from their trading, but if they are trading purely for the reasons noted, they do not expect to obtain returns in excess of the normal expected returns associated with holding (or shorting) securities.

Economists often call these utilitarian traders noise traders because their trading is unrelated to fundamental values. Accordingly, if their trading pushes prices around, prices will be less informative. Statisticians say that such prices are noisy estimates of fundamental value.

2 Informed traders

Informed traders collect information that allows them to predict futures prices. They buy when they expect prices to be higher and sell otherwise. Although they often are wrong, successful informed trades are right more often than they are wrong and therefore profit from their efforts. Informed traders base their trades on analyses of data that they believe will help them predict future values. Their information may include data about fundamental security values, or it may include data about the trades that other traders will likely do in the future.

Informed traders employ three main trading strategies. They may base their trades on estimates of fundamental values, on news about changes in fundamental values, or predictions about what other traders will do.

Value-motivated traders estimate fundamental security values. They then buy if their value estimates are sufficiently greater than market prices, and they sell if their value estimates are sufficiently lower. They estimate fundamental values by collecting and analyzing all information that their research budgets allow them to obtain. Since data collection and analysis are expensive, value-motivated traders can only profit if their trading gains are greater than their research costs.

News traders trade on news about events that change fundamental values. They buy when they believe that values will rise in response to an event, and they sell when they believe that values will fall. Since the effect on values of many events are quite obvious, news traders must trade very quickly to profit from new information. They therefore invest in systems that allow them to obtain and act upon information quickly. Since these systems can be expensive to build and operate, news traders can only profit if their trading gains are greater than their information collection costs.

Order anticipators try to predict the trades that other traders will do. If they expect that other traders will buy substantial quantities of securities and thereby increase prices, they try to buy first to profit from the price increases. They likewise try to sell before other traders sell. Order anticipators generally increase the costs of liquidity for the traders before whom they trade. When order anticipators trade in front of orders that they know about, they are called front-runners. Fiduciary duty prevents brokers from front-running their clients’ orders or from knowingly allowing others to do so. In most markets such activities are illegal. However, informed traders often try to anticipate the orders that other traders intend to submit by using pattern analyses and psychological models. The other traders must be utilitarian traders because traders cannot predict the trades of value-motivated traders or news traders without the information upon which these other informed traders base their trades.

3 Dealers

Dealers are traders who supply liquidity—the ability to trade when you want to trade—to other traders. They generally post quotes or limit orders that give other traders options to trade. Dealers profit by selling to buyers at offer prices that are slightly higher than the bid prices at which they buy from sellers. If the average spreads that they obtain between the prices at which they sell and the prices at which they buy are sufficiently large, their dealing will be profitable.

Dealers risk that prices will fall after they have bought or that prices will rise after they sell. When such price changes occur, they may not be able to trade out of their positions at a profit. They therefore hope to sell immediately after they buy and vice versa.

Dealers generally do not know much about fundamental values. They do know that if they set quotes too low, they will receive many buy orders and few sell orders. Likewise, if they set their quotes too high, they will receive many sell orders but few buy orders. Since they want to sell after they buy and buy after they sell, they try very hard to find the prices at which buyers and sellers are willing to trade equal volumes. These prices are called market clearing prices. Market prices differ from fundamental values when traders do not know fundamental values well, as is generally the case.

4 Adverse selection

Dealers and other traders who supply liquidity lose on average to well-informed traders. When well informed traders expect prices to fall, they sell. The dealers who buy from them lose if prices fall before they can sell their positions. Dealers likewise tend to lose to well-informed traders when the informed traders expect prices to rise.

Economists call this problem the adverse selection problem. The problem results because informed traders do not trade at random. Rather, their trading is correlated with future price changes: They buy when they expect prices to be higher and sell when they expect prices to be lower. If they realize their expectations, whoever traded with them loses. Dealers obtain adverse results—trading losses—when trading with well informed traders because the well informed traders more often than not select the profitable side of the market when they trade.

Dealers must quote bid/ask spreads large enough to recover from utilitarian traders what they lose to informed traders. Utilitarian traders thus lose to informed traders (through the intermediation of dealers) even if they trade at random because they must pay wide spreads. Adverse selection thus makes liquidity expensive. Utilitarian traders can avoid these losses by trading infrequently. If few utilitarian traders trade, informed traders will be a substantial fraction of the total order flow and bid/ask spreads will be very large. The informed traders will not be able to trade much, which will decrease their profits and decrease the resources that they spend on research, which will make prices less informative.

In the extreme, if informed traders are a substantial fraction of the total order flow, the spreads that dealers must quote to survive may be to large to support a viable market and the market will fail to operate. Averse selection thus explains why small stocks for which information is not widely disseminated tend to trade in less liquid and less informationally efficient markets than do larger stocks. Many exchanges that have started special markets for emerging companies have discovered that these markets often do not operate well due to the adverse selection problem.

The adverse selection problem has pervasive effects throughout all aspects of trading. Consider some examples of how adverse selection affects trading strategies, exchange design, and the design of financial products:

• Dealers try to avoid trading with well informed traders if they can do so. Many dealers internalize retail order flows to avoid the losses that they would incur trading with well informed institutions at exchanges.

• Dealers rarely will offer to trade large size to anonymous traders. They want to know with whom they are trading so that they can avoid losing to well-informed traders.

• Since dealers who can avoid adverse selection offer more liquidity, exchanges are very keen on creating trading mechanisms that protect dealers from adverse selection. For example, trading halt rules generally halt trading when dealers would be most vulnerable to informed traders.

• Many block brokers permit their clients to specify with whom they are willing to trade so that they do not trade with traders such as hedge funds that are likely to be well informed.

• Exchanges and regulators generally ban trading on inside information. These bans protect dealers from losing to well-informed traders. With this protection, the exchanges hope that dealers will offer more liquidity to other traders.

• Exchanges and others have created many index products that help investors purchase exposure to market-wide risks through a single transaction rather than through multiple transactions in many individual securities markets. Liquidity generally is cheaper in index markets than in individual security markets because adverse selection is a smaller problem in the index markets than in securities markets. Generally, few if any people reliably have deep insights into market-wide valuations whereas some traders often are well informed about individual security values.

5 The zero-sum game

Trading is a zero-sum game with respect to trading profits. The profits that buyers make are profits foregone by sellers, and the losses that buyers incur are losses avoided by sellers.

If traders were only motivated by expected trading profits, no rational traders would trade. The least well-informed traders would recognize that they would lose on average when trading so they would not trade. The least well-informed traders among the remaining traders also would not trade because they too would recognize that they would lose on average. The logical end to this argument is that no traders will trade with each other if they are only motivated by expected trading profits. In which case, markets would have no liquidity and prices would not be informative.

Fortunately, trading is not a zero-sum game when utilitarian traders are included. Utilitarian traders trade because they obtain benefits besides expected trading profits when they trade. As noted above, these benefits include moving money through time, risk management, tax avoidance, and entertainment. The losses that utilitarian traders sustain when trading with informed traders are the costs they must bear to obtain the various services that they seek from using the markets. The equivalent gains that the informed traders make fund their efforts to acquire information, and their trading on that information makes prices more informative. Utilitarian trading thus indirectly funds price efficiency. Markets exist only when traders are interested in trading for reasons besides trading profits. Without utilitarian traders, markets fail.

Accordingly, exchanges devote substantial resources to identifying products that will interest utilitarian traders. Examples of such products are investment vehicles such as ETFs that allow investors to easily move money through time, futures and options contracts that allow traders to offset risks that scare them, and levered vehicles such as contracts for differences, options, and levered ETFs that strongly attract gamblers as well as many other types of traders. Markets that have many utilitarian traders tend to be liquid markets with informationally efficient prices. Ironically, although utilitarian trading can make prices less informative in the short run, it ultimately provides the resources that informed traders need to conduct and act upon their research, and thus indirectly makes price more informative in the long run.

6 Informative prices

When informed traders base their trades on fundamental analyses of value, their trades tend to push prices towards their estimates of value. If their estimates of value are higher than current prices, they buy and push prices up towards their estimates of value. Conversely, if their estimates of value are lower than current prices, they sell (or sell short) and push prices down towards their estimates of value. Their trading thus makes prices informative. When prices reflect their information, market prices are close to fundamental values and informed traders cannot profit from additional trading.

Although many traders hope to trade successfully by carefully analyzing information, few are able to consistently profit. Those who rationally expect to profit on average are truly informed traders. Traders can rationally expect to profit from trading on information when they are confident that their information is not already in the price.

Economists call the other traders pseudo-informed traders. Pseudo-informed traders think that they are trading on information, but their information is either already in the price, or they are not able to properly analyze its implications for future prices. In either event, their trading is futile since it does not produce trading profits on average. If their trading pushes price around, price will be less informative, and they will ultimately lose money when prices return to values. Pseudo-informed traders thus are actually noise traders.

7 Market efficiency

Economists say that markets are informationally efficient with respect to some set of information when traders cannot profit by using that information to predict future prices. They say that prices are weak-form efficient when traders cannot predict future price changes based on past price changes. Prices are semi-strong form efficient when traders cannot predict future price changes based on any public information. Strong-form efficiency holds that prices cannot be predicted with any information, public or private. Few people believe that markets are strong-form efficient since insider trading on private information frequently can be exceptionally profitable.

The efficient markets hypothesis is a conjecture that the markets are semi-strong form efficient. Many studies indicate that this hypothesis is correct. This result is not surprising. If many traders knew that they could trade profitably using widely available public information, they would do so. Their efforts to profit from the information would cause prices to reflect that information, which would ensure that no one could then profit from the information. The competition among informed traders to profit ensures that prices are quite informative. It also makes being a successful informed trader very difficult.

Successful informed traders must trade on information that is not widely available to others. Such information is either privately obtained, or it is created through private analyses of publically available information. Since both processes are expensive, the trading profits that informed traders generate must cover the expenses of generating their predictions.

Rational traders who cannot obtain valuable insights into future prices do not speculate on future values. Instead, they confine their trading to only that trading which is necessary to obtain other objectives such as risk management or investment. Such traders typically trade only index products.

Although empirical evidence suggests that the efficient market hypothesis is essentially true, logically it cannot always be true for all traders. If it were always true, prices would always equal fundamental values so that informed traders could never profit from research into fundamental values. In which case, informed traders would not invest to obtain information and they would not trade. But if informed traders do not trade, prices would not be informative. The efficient market hypothesis therefore cannot always be true. In particular, prices do not always equal values.

Informed trading ensures that prices generally are near their fundamental values so that further informed trading is not profitable. When then is informed trading profitable? Informed trading is profitable when values change but prices do not change, or when price change and values do not change. In either case, prices differ from values and informed traders will have an opportunity to trade.

Values change in response to material events. Traders who are aware of these events and their implications for value profit if they can trade before other traders recognize that values have changed. These traders are the news traders described above.

Prices can change when values do not change when utilitarian traders trade substantial volume on the same side of the markets. Their efforts to fill their trades cause prices to move independently of fundamental values. The traders best able to recognize this situation are value-motivated traders who estimate security values and who trade when they perceive that prices differ from their estimates of value.

Since value-motivated traders trade in response to the demands for liquidity made by the utilitarian traders, they supply liquidity to the market. Value-motivated traders generally are willing to provide more liquidity than dealer will because they know fundamental values much better than do dealers. As well-informed traders, they are much less afraid of trading with better informed traders than are dealers, who generally only know market values and not also security values. Accordingly, value-motivated traders are the ultimate suppliers of liquidity. Dealers frequently trade with value-motivated traders when they are uncomfortable with their inventory positions.

Public disclosure programs mandated by exchanges or by regulatory agencies increase price efficiency by reducing the costs of research for informed traders. With lower costs, informed traders require less liquidity to obtain a given level of profitability. Prices therefore will be more informative in illiquid markets when material information about security values is readily available.

Implications of liquidity search problems for market structures

Traders face two significant problems when trying to fill their orders. First, and most obviously, traders must find traders who are willing to take the other sides of their trades. Second, while searching for counterparties, they must be careful that their actions do not adversely affect the prices at which they ultimately trade: Other traders may front-run their orders or withdraw liquidity from them. These problems are most severe for large traders.

To help traders solve these problems, exchanges, brokers, and alternative trading systems have added various features to their trading systems. Understanding how these problems affect trading thus is necessary to understand why markets are structured as they are.

1 The search of liquidity

The problem of finding traders to take to the other side of a trade is most easily solved when all traders participate in the same trading system. When willing buyers and sellers are present at the same time and price, exchanges or brokers can easily match them together.

Exchange and brokerage trading systems facilitate the search for liquidity by concentrating order flow at a single place. Traders who want to buy or sell seek out these systems because that is where sellers and buyers generally go when they want to trade.

Call markets further concentrate liquidity by calling all traders to trade at the same point in time. The resulting markets can be very liquid at the times of their calls, but they are completely illiquid between calls. The markets calls that open and close many exchange trading sessions are often the most liquid periods of the trading day.

In continuous trading market, traders can arrange trades at any time that the market is open. However, buyers and sellers often are not present at the same time. Dealers commonly offer liquidity in such markets. They may buy from a seller in the morning and sell to a buyer in the afternoon, or vice versa. The effect of their trading is to connect buyers and sellers who come to the same place to trade, but who arrive at different times. Exchanges cultivate relationships with dealers to ensure that their continuous markets will be liquid.

Large trades are particularly hard to arrange because traders who are capable of taking the other side of a trade may not be present in the market. Many traders who ultimately prove willing to trade do not consider whether they would be willing to the trade until they are asked. Economists call such traders latent liquidity suppliers.

Block brokers facilitate large trades by keeping track of who owns large blocks of securities that they might sell and of who might be interested in purchasing large blocks of securities. When asked by a client to buy or sell a block, they then consider who might be willing to take the other side. Successful block brokers therefore must have many clients who they know well. Block brokers generally run their businesses away from exchanges because the information that they must collect and communicate rarely appears on exchange floors or in exchange trading systems.

2 Informed trading issues

Concerns about informed trading also make trading large blocks difficult. Most traders presume that large traders are well informed because well-informed traders tend to trade large orders and because large traders generally can afford the research necessary to become well informed. As a consequence, dealers and other traders are unwilling to fill large orders without a substantial price concession if they suspect that the large trader may be well informed.

Block dealers and block brokers help solve this problem for large utilitarian traders by confirming that the large traders are indeed utilitarian traders and not well-informed traders. They make these determinations by knowing their clients and the reasons why they trade.

The block dealers and brokers must always consider whether their clients have based their trading decisions on material information that is not yet in the price. Dealers who facilitate client trades stake their wealth on the quality of these audits. Block brokers stake their reputations on the quality of these audits when they introduce a large trader to their other clients who might take the other side of the trade. These research activities generally take place away from exchanges because exchanges usually do not provide the information resources that would allow traders to determine who is well informed and who is not.

3 Quote matching issues

Large traders who expose their limit orders risk that other traders will employ a strategy called quote-matching. The quote-matching is best explained through an example. Suppose that a large trader places a limit order to buy at 20. A clever trade may see this order and immediately try to buy ahead of it, perhaps by placing an order at 20 at another exchange, or by placing an order at a tick better at the same exchange. If the clever trader’s order fills, the clever trader will have an interesting position in the market. If prices subsequently rise, the trader will profit to the extent of the rise. But if prices appear to be falling, perhaps because the prices of correlated stocks or indices are falling, the clever trader will try to sell to the large trader at 20. If the clever trader can make trade decisions faster the large trader can revise or cancel his order, and faster than can other traders competing for the opportunity to trade, the clever trader be able to limit his losses. The clever trader thus profits on one side, but loses little on the other side. The large trader has the opposite position: If prices rise, he may fail to trade and wish that he had. If prices fall, he may trade and wish that he had not. The profits that the clever trader makes are lost opportunities to the large trader.

The quote-matching strategy is profitable when very fast traders can extract the option values of limit orders. Orders have option values because they give other traders rights to trade at fixed prices.

Large traders avoid quote-matching losses by limiting the exposure of their orders. Exchanges, brokers, and alternative trading systems have developed many systems to help traders manage the exposure of their orders. On floor-based exchanges, large traders trust their orders to floor brokers with the understanding that the brokers will only display the orders to traders who the brokers expect will fill the orders and who the brokers trust will not front-run the orders. Off-floor brokers likewise carefully manage the exposure of the orders entrusted to them.

Most electronic exchanges and alternative trading systems now permit traders to hide all or a portion of their orders. The orders are either hidden at their limit price, or they display at their limit price and provide for a specified degree of discretion to trade at a better price that is not displayed. Many of these systems are called dark pools because they do not expose orders to the public.

Traders discover these orders by submitting limit orders at the prices at which they hope to find hidden liquidity. They usually mark these limit orders as immediate or cancel (IOC) so that their own efforts to find liquidity remain hidden if they do not find liquidity at a given price. Using electronic systems, traders routinely sweep many markets with IOC orders in an effort to fill their orders at improved prices and sizes. Some brokerage systems submit more than 100 IOC orders for each filled order as they sweep various markets and prices in the search for hidden liquidity. This process occurs very quickly since the roundtrip time between submission and the report of an unfilled order is often less than 30 milliseconds. Hidden order facilities protect traders from frontrunners because traders can only learn about hidden orders by committing to trade with them, and then only to the extent that they are willing to trade.

Repeated trade reports at prices or quantities that reveal hidden liquidity often predict additional liquidity at that price. Some traders monitor the market for these situations and they front-run orders that they suspect are hidden. Such traders risk that no liquidity may remain where they expect it to reside, or that the order may be cancelled.

4 Other front-running issues

Traders who fill large orders often must move prices substantially to obtain the liquidity necessary to fill their orders. These price concessions are especially large when other traders believe that the large traders are well informed, but they may still be quite significant even if the large trader is a utilitarian trader. The concessions are necessary to encourage traders who otherwise would not be willing to buy or sell to trade. Large traders are said to exert price pressure as they try to fill their orders.

Expectations of these price changes make filling large orders very difficult. If other traders become aware of a large buy order, some may immediately buy in front of the order in an effort to profit from the expected price change. Such trades increase the ultimate costs of filling large orders.

Also, if traders who have posted limit orders or quotes are aware of these large orders, they may withdraw their offers of liquidity so that they can reprice them further from the current market in anticipation of the price pressure of the large traders’ orders. These traders are said to fade their orders from the market so that large traders ultimately pay more to fill their orders.

Both problems—front-running by traders on the same side and fading by liquidity suppliers on the opposite side make large traders are very reluctant to disclose the sizes of their orders. To avoid these problems, large traders use the hidden order facilities described above when posting limit orders. If they are using marketable limit orders, they attach immediate-or-cancel instructions to their orders to ensure that they do not display after they have taken all liquidity at a given price. They may also simultaneously submit orders to all markets at the same time to collect as much liquidity as they can at a given price or prices before liquidity suppliers realize that a large trader is present.

5 Price discrimination

Large traders generally will break their large orders into smaller pieces so that can fill the first pieces at the best available prices and then only fill the remaining sizes at inferior prices. Since traders who offer liquidity are aware of this problem, they tend not to post much size at the best quoted prices. Those who do fail to earn the price concessions that large traders typically pay to fill an order.

As discussed above, large traders seeking substantial size often can find such size at better prices if they use the services of a block broker or dealer. However, dealers do not want to offer liquidity and brokers do not want to arrange for liquidity if the large trader intends to price discriminate. Doing so would produce immediate losses for dealers or the brokers’ contra-side clients when the large trader tries to trade more size at inferior prices. To avoid this problem, block brokers want to know the full size of an order so that they can price it accordingly.

One of the more important functions of the block trading market is determine the true size of large orders. Dealers and brokers ask their clients what the full sizes of their orders are and they attempt to keep them honest by paying close attention to their clients’ subsequent trades and by making it clear that they will not again arrange trades for clients who prove to be dishonest. Those traders who can credibly convince others that they will not price discriminate often obtain better average prices for their orders than they would if they tried to price discriminate.

6 Informed trading

Informed trading is most profitable when the informed traders can trade substantial size with little market impact. Since no one wants to trade with a well-informed trader, informed traders must employ stealth trading strategies. In general, they try to appear to be utilitarian traders.

Informed traders prefer to trade in anonymous markets. In those markets that reveal trader identities, they may use brokers as “beards” behind which they can hide, if regulations permit.

Informed traders often break their orders into small pieces that they doll out over time to avoid recognition. This strategy works only when they are in unique possession of material information that will not soon become public. If the information will soon become public, or if many other traders also have the information, they must trade quickly to capitalize on their informational advantage.

Dealers pay close attention to the urgency with which traders seek to trade. If they believe that many traders all want to quickly trade on the same side of the market, they fade from the market and adjust prices quickly to restore a two-sided order flow.

Exchanges often help protect dealers from informed trading by halting markets when information is pending or by halting trading when prices have (or would) move substantially in response to a one-sided surge of orders. These trade halt rules protect liquidity suppliers from losing to informed traders and to large traders who seek to price discriminate. With such protections, the dealers will offer more liquidity to other traders.

Dealers must be very careful when trading with anonymous traders. Since informed traders can break their orders up and time their submissions, they must be careful to recognize that small persistent short-term order imbalances may turn into long-term order imbalances. Accordingly they must adjust their expectations of value in response to every order that they see since any anonymous order may come from an informed trader. When their expectations change sufficiently, they change their quotes.

Dealers also must also very careful to change prices uniformly in response to small and large orders to prevent losing to market manipulations. For example, if a dealer believes that large traders are well informed and small traders are not, a market manipulator can increase prices with several of large purchases that change prices substantially and then sell out with many small trades that collectively do not change prices as much. If the cumulative price impact of the large trades is greater than that of the small trades, the average sales price will be greater than the average purchase price, and the manipulator will profit.

Exchanges and the governmental bodies that regulate trading generally make market manipulation illegal to protect dealers and other traders. However, enforcement is extremely difficult because manipulators invariably claim to be informed traders who bought because they thought prices were low and sold to lock in their gains when prices rose.

Exchange rules affect the provision of liquidity

Exchanges and other trading systems choose their trading rules carefully to facilitate traders. They rules typically affect incentives to take or supply liquidity by various types of traders.

Order precedence rules determine for which traders the trading system will first arrange trades. The first order precedence rule is price priority. Exchanges invariably give precedence to those traders who offer the best prices since such prices will most likely attract traders on the other side of the market. Accordingly, impatient traders who wish to trade quickly must bid higher prices when buying or offer lower prices when selling.

The remaining order precedence rules are called secondary precedence rules because they determine who has precedence at a given price. Trading systems vary in their secondary precedence rules. At those systems that permit hidden orders, displayed orders (or the displayed component of partially hidden order) have precedence over those orders that are not displayed. This rule encourages traders to display their orders thereby making it easier for the exchange to attract order flow.

The next secondary precedence rule usually is some version of time precedence. Time precedence rules give precedence to orders that arrive earlier than other orders. Exchanges vary in their time precedence rules. Strict time precedence gives precedence to orders at a given price in the order in which they arrive. No order can be filled until all earlier orders have filled. In contrast, floor based exchanges and some electronic exchanges give time precedence only to the first order to arrive at a given price. At such exchanges, once that order is filled, all other orders are generally are filled on a pro-rata basis. Time precedence rules encourage traders seeking to trade to submit their orders as early as possible. They also reward those traders who improve prices with order flow, thereby giving traders incentive to improve price.

Pro-rata allocation schemes give traders who post large orders a greater share of the allocation of incoming marketable orders. In such systems, traders often post much large orders than they intend to fill with the hope of filling their desired order size, but they must be careful because they given very large traders opportunity to trade. Pro-rata allocations rules favor large traders and fast traders who can quickly cancel their orders in response to changing market conditions. These rules discriminate against small retail traders for whom posting liquidity is unwise because their orders will only fill when nobody else is willing to trade at that price. Exchanges adopt pro-rata allocation rules to maximize displayed total order size.

Secondary trading rules are not meaningful when the exchange tick size—the minimum variation by which prices can change—is small. If the tick size is small, traders who do not have precedence at a given price will obtain it by improving price by a trivial amount. A small tick size thus favors price competition and deemphasizes incentives to post and display orders early.

However, a small tick size reduces the costs of front-running and quote matching strategies. Given traders precedence over large orders without requiring that they substantially improve prices allows them to extract more of the option value of large orders since they gain more if prices move in their direction and lose less if they have to trade out of their positions.

Many exchanges give special privileges to dealers who they may call specialists, designated market makers, or designated dealers. The special privileges often allow the dealers to take precedence over standing orders for a fraction of the incoming order size, or allow them to improve price based on information that other traders may not have, or allow them to guarantee execution with the option to not participating in the trade should another trader come along. Exchanges give these valuable privileges in exchange for special services that they expect from their designated dealers. In particular, they generally expect that the dealers make markets when others will not so that some market for each security will always exist at the exchange. These special privileges generally hurt limit order traders who offer liquidity because the special privileges given dealers precedence that otherwise would have gone to the limit orders. The special privileges may also hurt traders who take liquidity by limiting the opportunities for price improvement that they otherwise might have.

Many exchanges also have public order precedence rules. A public order precedence rule give precedence to public traders over member traders at a given price. These rules helped prevent front-running and generally increased public confidence in exchanges. They are less common now that as more trading is now organized on electronic trading systems.

The cost of liquidity

Liquidity too often is a poorly defined concept. It often means different things to different people. The confusion undoubtedly is due to its very dimensions, all of which are related to characteristics of the bilateral search among traders for the best price. Perhaps the most all encompassing definition of liquidity is that it is the ability to quickly buy or sell substantial size at low cost when you want to trade. This definition hints at several liquidity dimensions. “Low cost” refers to a dimension called width. It is usually measured by bid/ask spread, market impact, and commissions. “Size” refers to a dimension called depth, the ability to trade a quantity at a given price. Width and depth are closely related. Width is cost for a given quantity whereas depth is quantity for a given cost. “Quickly” refers a dimension called immediacy. It is usually measured by the time it takes to arrange a trade of a given size for a given cost.

These various dimensions of liquidity are related. Traders generally can trade more size if they are willing to provide greater price concessions: Depth increases with width. Likewise, at a given cost, traders generally can find more size if they search longer. Also, traders often can trade a given size at lower cost if they search longer. The connection between these dimensions comes from fact that they all are determined in the same search problem. In general, “ability to trade” depends on how much the trader wants to trade, how much the trader is willing to pay for the trade, and how long the trader looks for counterparties. One market is more liquid than another if the probability of traded a given size at a given cost within a given time period is greater at one market than the other.

Several factors determine market liquidity. The most important one is the interest of utilitarian traders. If no utilitarian traders are interested in trading, the market simply will not exist because rational profit motivated traders cannot all expect to profit when trading with each other.

Volatility is the next most important determinant of liquidity. Volatile markets tend to have wide spreads as dealers and other traders try to contain the option values in their orders. The value of a fixed price limit order or quote increases with volatility because volatility increases the potential benefits from the quote-matching strategy. Accordingly, volatile markets tend to have wide spreads.

Adverse selection also increases bid/ask spreads because dealers must ensure that they can obtain enough profit from utilitarian traders to cover their losses to uninformed traders. Exchanges try to control adverse selection by mandating substantial financial disclosure by their listed firms. These disclosures reduce information asymmetries and thereby reduce informed trading.

Order submission strategy and equilibrium bid/ask spreads

Traders manage their transaction costs by carefully choosing their search strategies. At organized exchanges where limit orders are matched with marketable orders, the main order submission decision is whether to take liquidity with a marketable order or to offer liquidity by posting a standing limit order. The tradeoff depends on several factors, foremost of which are bid/ask spreads and cost of time. All other things equal, traders post orders when spreads are wider and they take liquidity when spreads are smaller. Among traders, those who most value their time or who most need to trade quickly (because the information upon which they are trading will rapidly become better known) use marketable orders because they execute quickly. Those who can wait for a better price post limit orders and wait for the market to come to them.

Traders say that the bid/ask spread is the price of liquidity. When that price is high, traders offer liquidity. When the price is low, traders take liquidity. In fact the bid/ask spread is the costs of trading two orders: a market order to buy and a market order to sell, but simultaneously submitted. These trades will accomplish nothing on net, but they will lose the bid/ask spread for each share traded twice. Accordingly, the cost of trading a market order is one half the bid/ask spread.

The maximum amount of trading can take place only when traders submit equal volumes of posted limit orders and of marketable orders. This occurs only when the bid/ask spread—the price of liquidity—is set right. Fortunately, the market determines this bid/ask spread which economists call the equilibrium spread. The following argument provides a sketch of how spreads are determined.

If spreads are too wide, most traders will post orders and little trade will take place. In which case, some traders will narrow their spreads to improve price in the hope of encouraging some traders to switch from posting liquidity to taking liquidity. If spreads are too narrow, most traders will try to take liquidity and few will post liquidity. Those who post will quickly have their orders filled so that bid/ask spreads widen. The wider spreads will discourage some traders from taking liquidity in favor of offering liquidity. These arguments indicate that markets will find some intermediate bid/ask spread that just balances the demand for liquidity with the supply of liquidity.

Understanding how spreads are determined in equilibrium provides tools for predicting what effects make or take pricing has on bid/ask spreads. Some exchanges charge a simple transaction fee for arranging trades. The fee may be borne by the seller or the buyer, or split among them. In contrast, other exchanges charge an access fee to traders who trade by taking their markets with marketable orders. These exchanges also pay a liquidity rebate to traders who trade by making markets with posted limit orders. The difference between the access fee and the liquidity rebate is the net revenue earning by the exchange for arranging trades. This difference is generally about the same size as the transaction fees charged by exchanges that use the transaction fee model.

Since the access fee makes using market orders expensive and the liquidity rebate makes using limit orders attractive, and increase in both of these rates would cause traders to shift from submitting market orders to limit orders if spreads remained constant. However, in equilibrium, equal volumes of marketable orders and limit orders must be matched. This condition will only be met if bid/ask spreads decrease. Since traders generally only care about net prices, the net price of liquidity (half the bid/ask spread plus the access fee) will be the same regardless of how high the access fee and liquidity rebate are set, as long as the difference is constant. Accordingly, any increase in the access fee and liquidity rebate will produce twice the decrease in equilibrium spreads.

Make-or-take pricing thus distorts quoted bid/ask spreads. This result is extremely important to understanding the competition between dealers and exchanges and among exchanges.

The competitions to supply and organize liquidity

Many traders compete to supply liquidity. Dealers compete with public limit order traders, and both compete with arbitrageurs.

Public limit order traders often can push dealers out of a market because the public traders generally want to fill their orders. They offer liquidity with the hope of improving the price of their orders. Their greatest risk when doing so is that they will fail to trade when informed traders move prices away from their orders. They minimize this probability by pricing their orders aggressively. In contrast, dealers trade to profit from offering liquidity. Since they ultimately must trade on the other side of the market when they fill an order, their greatest risk is that informed traders will cause prices to move before they can trade out of their position. They minimize the losses associated with this adverse selection risk by moving their orders away from the market. The different risks that they two types of traders perceive in response to informed trading cause the public limit order traders to be more aggressive and the dealers to be less aggressive. If enough public traders are in the market, pure dealing strategies become unprofitable.

Arbitrageurs also compete with dealer to profit liquidity. As discussed above, dealers essentially match buyers and sellers arriving in the same market at different points of time. In contrast, arbitrageurs match buyers and sellers arriving at different markets for essentially the same risks at the same time. For example, an arbitrageur may offer to buy in one market with expectation that he can sell the same security in another market at a higher price. This often happens when a large seller depresses prices in one market, but not in another market. In this case, the arbitrageur competes with the dealer to service the seller.

To protect their member dealers from this competition, some exchanges have tried to place limits on traders conducting arbitrage. Such limits have been problematic because identifying arbitrage trade is difficult and because regulators generally support equal and fair access for all traders.

Dealers also compete with brokers and exchanges to fill orders. Dealers fill orders for their own accounts whereas brokers and exchanges fill orders by matching their clients. Although many dealers make markets at exchanges, they generally prefer to make markets away from exchanges where information is not so widely available to their clients. Exchanges and dealers thus often have conflicting objectives with respect to how exchanges operate.

Finally, brokers and exchanges often compete with each to arrange trades. When permitted by regulatory authorities, many brokers first try to match orders among their clients before sending unmatched remainders to an exchange.

Since brokers and exchanges are in the same business, functional distinctions between exchanges and brokers often are subtle, especially for brokers who maintain electronic limit order books and automated order matching systems. The primary distinction is regulatory. Many exchanges regulate their members’ business activities and their listed firms’ capital structure and information disclosures whereas brokers only regulate trading in their trading systems.

The various competitions to supply and organize liquidity help reduce transaction costs for traders and provide them with innovative exchange services. The competitions among dealers, arbitrageurs and brokers to fill orders ensure that traders obtain liquidity at the lowest cost possible. The competitions among brokers and exchanges have led to the creation diverse trading systems designed to serve the special needs of various types of traders. Most of the dark pools exist because exchanges were unable or unwilling to meet the needs of large traders in an increasing electronic environment.

The two mostly incompatible competitions

Two competitions occur in securities markets: the competition among traders for the best price, and the competition among exchanges and brokers to host the first competition. Unfortunately, these two competitions generally interact with each other poorly. Most policies that would promote one competition hurt the other, and vice versa.

The competition for best price works best when all orders are brought to a single place so that traders can most easily find each other. This observation suggests that regulation should consolidate all trading to a single market. Indeed, many countries have adopted such policies. For example, US law allows exchanges to consolidate trading in a given futures contract to a single exchange. Likewise, several countries consolidate equity trading in local equities to a single national exchange.

Such regulatory consolidation completely destroys the competition among exchanges to provide exchange services. That competition only works when traders are free to route their orders to whatever exchange they believe best serves them. Where such freedoms exist, exchanges and brokers have competed to provide high quality low cost services. In many cases, these services are tailored to meet the special needs of various clienteles. However, the resulting fragmentation often concerns regulators who wonder whether the diversity of exchange platforms hurts significantly impairs the competition for best price.

In practice, most trading generally consolidates to a single exchange (if it can be wrested away from dealers) because traders generally go to where trading is most active. Practitioners say that “liquidity attracts liquidity.” Economists call this phenomenon the order flow externality. It exists because traders are attracted to the many free trading options provided by limit orders posted in an active market.

The order flow externality places a severe burden upon innovative exchange systems that try to compete with established exchanges. Even though many—perhaps all—traders may believe that the innovative exchange would provide higher quality exchange services than an incumbent, few traders will send their orders to the new system because they must execute their orders, and the only exchange where they can do so is the incumbent exchange. In such situations, innovations are adopted only when everyone coordinates a common move to the new exchange or when government intervention changes the rules of the game.

The order flow externality will not consolidate all trading to a single venue when the needs of traders vary substantially. For example, large traders support different trading systems than do retail traders, and informed traders favor different systems than do uninformed traders. When needs are sufficiently diverse, so will be the exchange systems that develop to satisfy them.

Although the resulting fragmentation complicates the search for best price, at least three considerations suggest that the problem may not be large. First, traders often will route their orders to the markets that do not provide them with the services that they most desire when trading opportunities at those markets are most attractive. Second, traders who are aware of trading opportunities in other markets will adjust their orders to reflect those conditions even if they cannot or will not route their orders to those markets. Third, arbitrageurs will move liquidity from one market to another market when prices differ enough to make their trading profitable. The costs of a fragmented system thus are best measured by the costs of routing orders, by the costs of building and maintaining consolidated information systems, and by the resources spent by arbitrageurs in pursuit of trading profits.

Most regulatory bodies oscillate over time between favoring the competition for best price and the competition for exchange services. Their decisions tend to depend on changing political philosophies and upon changes in technology that create new and compelling opportunities.

Lobbyists invariably argue that the policy that they favor is the pro-competitive policy. One side argues to improve or maintain the competition for best price while the order side argues to improve or maintain the competition for exchange services.

Some current regulatory issues

Chapter XX provides a broad survey of regulatory issues in exchange markets. This section provides a short discussion of the economics underlying a few current regulatory issues.

1 Make or take pricing

In the United States and in many other countries, principals of best execution require that dealers fill small orders at the best prices quoted at any accessible exchange when trading off an exchange. Exchanges and alternative trading systems known as ECNs that collect their fees using the make-or-take pricing model cause quoted bid/ask spreads to be smaller than they otherwise would be. The smaller spread disadvantages dealers who must fill orders at best quoted prices because they cannot charge their customers an access fee for trading with them. The make-or-take pricing model thus favors exchanges over dealers. To remain profitable, dealers most post their quotes at exchanges so that they can receive liquidity rebates when trading.

The make-or-take model also distorts the competition among exchanges. When brokers must route orders to exchanges based on the best quoted price and not best net price, make-or-take exchanges have an advantage over transaction fee exchanges because the former tend to have more aggressively priced orders as their liquidity suppliers compete to receive liquidity rebates. However, the narrower spreads do not provide a net benefit to customers who must pay access fees to access them.

2 Flash orders

Exchanges often receive orders that are not marketable at the receiving exchange but that are marketable at other exchanges. Rather than routing those orders to where they can immediately trade, some exchanges flash them to a set of designated traders for a short period of time that ranges between 30 and 150 milliseconds depending on the exchange. During the flash period, the first dealer willing to fill the flashed order at the best price available at another exchange, or at a better price, then fills the order. If no designated trader is willing to fill the order, the exchange then routes the order to the other exchange.

Flash orders generally benefit the traders who submit them because they often obtain quick executions at sometimes better prices and sometimes for more size than is displayed elsewhere. Since the better prices often come from make or take exchanges, traders also often benefit by avoiding the other exchange’s access fee.

Flash orders benefit the exchanges that flash them by allowing them to fill orders that otherwise would go to other exchanges.

Flash orders benefit the traders who fill them by allowing them to decide to whether they want to trade in response to an opportunity rather than by forcing them to commit to trade whenever the opportunity arises. The option not to trade is valuable to them, especially when they can determine that market conditions have suddenly changed.

The most obviously disadvantaged party is the trade offering the aggressively priced liquidity at another exchange. If the receiving exchange fills the flashed order, the aggressive trader at the other exchange will not be rewarded for posting an aggressive market. Worse, that trader may lose if the dealer filling the flash order is pursuing the quote matching strategy. The problem arises because exchanges do not give time precedence to orders at other exchanges.

The arguments for and against flash orders thus boil down to arguments for the two types of competitions. The affirmative argument favors the competition among exchanges to provide exchange services by allowing them to innovate to serve the needs both of the clients and of their principle liquidity suppliers. The negative argument favors the competition for best price by protecting the interests of the traders who improve markets.

Prohibiting flash orders also would reduce the importance of the order flow externality that protects incumbent exchanges with substantial order flow. Since the order flow externality impairs the competition among exchanges, the negative argument also improves somewhat the competition among exchanges to provide exchange services, although not necessarily the immediacy that filled flash orders provide.

The issue is further complicated by the fact that brokers can route to the best prices by themselves. They may choose not to avoid access fees, or for other reasons that public policy makers may or may not find admissible.

3 Market data, fast access, and high frequency trading

Access to market data and the ability to act upon it quickly is a key determinant of profitability for traders. Those traders who are immediately aware of prices and volumes both before and after trades take place have a substantial advantage over those who have less timely information or no information at all. The greatest advantage goes to those who can act on timely information before others can. Not surprisingly, questions of who has access to data and to order processing systems are quite contentious.

Generally those traders who already have the best access to market information are most interested in restricting access by others. For example, bond dealers throughout the world have resisted publication of bond trade prices. Their superior knowledge of trade prices gives them much greater power in their negotiations than their clients have. They are always willing to trade at prices favorable to them, but they will not trade at unfavorable prices. Their clients, who are less able to distinguish between favorable and unfavorable prices, often unknowingly trade at unfavorable prices.

Not surprisingly, retail clients in fixed income markets receive the worst executions because they have the least knowledge about bond values. Institutional clients, who trade more frequently and have better access to valuation models, obtain much better prices on average for their much larger transactions. This relationship between order size and cost of liquidity is opposite to the one normally observed in exchange markets that widely disseminate quotes and trade prices as they occur. Remarkably, liquidity costs for retail size trades in bond markets organized by dealers are substantially higher than liquidity costs for similar sized orders in equity markets organized by exchanges. The greater potential for informed trading in the equity markets than in the fixed income markets suggests that executions in those markets should be more expensive, not less expensive. Moreover, the full disclosure of trader identities in the fixed income dealer markets suggests that dealers should be better able to avoid informed trading than in exchange organized equity markets, where trader identities generally are not disclosed.

Historically, exchanges have been at the forefront of efforts to make prices more transparent, both before and after the trade. Transparent prices attracted customers to their markets by providing them a basis for ascertaining whether their trades occurred at fair prices.

Now that many exchanges are for-profit organizations, the potential for selling market data has encouraged them to make more data available to the public. Many exchanges now derive a substantial fraction of their revenues from sales of market data. These data include ultrafast data feeds that broadcast quotes, changes to limit order books, trade information, and changes in indices as they occur. The prices for these services are often quite high so that the only purchasers are those professional traders who can most profit from the information. Through the data revenue that they collect from these traders, exchanges effectively obtain a share of their trading profits.

Exchanges now also sell superior access to their order routing systems to proprietary traders. In particular, they allow traders to co-locate their computer servers in the same facilities in which the exchange servers are located. Proprietary trading systems running on co-located servers can respond much more quickly to new market information than can systems running on remote servers.

The speed advantage depends on the distance between computers, the speed of light, and the number of routers through which messages must pass before arriving at their destination. These differences can be quite significant. For example, at the speed of light, a message takes a little more than 4 milliseconds to travel the 800 miles between Chicago and New York. If it passes through only four routers on the way, each of which delays the message by one millisecond, the total time to complete a round trip would be 16 milliseconds. During this time period, a computer processor running at three gigahertz can do 48 million operations. Obviously, when two traders compete to exploit the same trading opportunity, the one that is closer to the information and closer to the means of acting upon it will be the first to profit from the opportunity. The closer traders will always be able to respond first, and they may be able to respond more intelligently if they use their time advantage to more thoroughly analyze market conditions.

Many market participants believe that allowing some traders superior access to information is unfair. Many also question whether exchanges should even have the right to sell data, none of which would have any value were it not for the traders who use the exchange. Others simply note that even on a level playing field, better players will always have an advantage.

The profits that high frequency traders make come from many trading strategies. The most important of which involve supplying liquidity to utilitarian traders either as dealers or arbitrageurs. Many commentators recognize that these profits must come from utilitarian traders without recognizing the value of the liquidity services that the high frequency traders provide. In fact, because high frequency trading is very competitive, and because the marginal cost of operating trading systems once built is low, electronic high frequency trading has undoubtedly substantially reduced the liquidity costs for utilitarian traders. The real losers have been traditional dealers and arbitrageurs who have not build electronic systems that can compete with those proprietary traders who have.

4 Internalization, payments for order flow, and best execution

Many broker-dealers also fill their client orders themselves in a process called internalization. Acting as dealers, these brokers fill their client orders off exchange.

Many brokers also route client orders to dealers in exchange for payments from the dealers. The dealers then fill these orders off exchange.

The potential for abuse in such arrangements is very high. Acting as agent for their clients, brokers must seek the best prices for their clients’ orders. But when also acting as a dealer to fill those orders, they profit most when the fill prices are least favorable to their clients. If they sell order flow to dealers, the payments that they can obtain depend on the profits that the dealers make, which are greatest when the clients receive poor prices. In both cases, the immediate incentives to obtain best execution for their orders are small.

In principle, these problems would not arise if they clients could easily determine whether their brokers were obtaining best execution for their orders. If not, they would demand better service from their brokers or send their orders to other brokers who would provide better service. Best execution is generally understood to be good execution prices for marketable orders, though it may also include other dimensions of execution quality such as quick execution.

In practice, brokerage clients, and especially retail clients—cannot easily determine whether the prices that their brokers obtain for their orders are as good as could have been obtained. To do so, they must know what market conditions prevailed when they submitted their orders, and they must compare their execution prices to the prices that they would have expected to receive given those market conditions. This process is extremely data intensive, and reliable results require analytic modeling skills that are substantially beyond the expertise of most clients. At best, retail clients only have a weak sense of whether their executions occur at favorable prices, and then only to the extent that their execution prices are at or within the bid/ask prices that their brokers may or may not present to them, and even then, only if they are paying attention. In contrast, institutional clients generally employ consultants to analyze the executions of their orders.

Concerns about the quality of execution in these relationships have led brokers and the authorities that regulate them to require that small orders executed off-exchange be executed at the best prices quoted on the exchanges, or at better prices. To meet their best execution requirements, brokers increasingly demand that they dealers to whom they route orders provide improved prices.

These guarantees provide some assurance of execution quality in instruments that are exchange traded. Not surprisingly, when decimalization and increased automation of exchange systems and of proprietary dealing systems decreased bid/ask spreads in these markets, payments for order flow and internalized dealing profits also substantially decreased. However, payments for order flow and internalized dealing profits remain very high in instruments such as fixed income for which no exchange markets exist.

Dealers only pay for order flow that they believe comes largely from utilitarian traders. In particular, they will not pay for order flow that comes from informed traders since such order flow is tool costly for them to fill. Broker-dealers likewise only internalize those orders that they believe and benign and pass the remaining orders on to exchanges.

The diversion of order flow from exchanges decreases the market quality at the exchanges by removing utilitarian order flow. The remaining order flow is better informed and thus harder to fill profitably. As order flow is diverted from exchanges, exchange bid/ask spreads widen. In the extreme, exchanges will fail and no bid/ask spreads will be available.

These issues greatly concern many practitioners and regulators who value the transparency of the exchange markets and the role exchange transparency plays in regulating best execution for off-exchange trades. They also note that widening of bid/ask spreads from order flow diversion makes off-exchange trading more profitable, which will lead to a further diversion of order flow.

Although payments for order flow and internalized dealing profits would seem to directly benefit brokers, brokers only benefit if they can obtain order flow from their clients. When order flow is more valuable to brokers because payments for order flow are high or internalized profits are high, brokers compete fiercely among themselves to obtain the order flow from which they profit. Their competition lowers the commissions that they charge their clients and it improves the quality of the services that their clients value and can easily recognize. Since most brokerage markets are quite competitive, brokers end up competing away the benefits that they obtain from the valuable order flow so that they just earn normal economic profits.

Since broker-dealers try to internalize and sell only order flow from utilitarian traders, the profits that they earn on that order flow are higher than the profits that they would earn if they traded a similar quantity of order flow at an exchange where they would be exposed the more adverse selection from well-informed traders. With competitive brokerage markets, these additional profits will return to the clients that generate the order flows. Thus, if the competition for order flow is efficient, internalization benefits utilitarian clients by providing them with better net prices than they otherwise could obtain if their orders were mixed with those of informed traders and not processed separately.

No competition is perfect, however. As market structures become more convoluted, more profits stay with the intermediaries and brokers generate more waste as they provide customers with services to attract their order flow that they may not fully value. These issues undoubtedly will long concern regulators and practitioners.

Conclusion

The ideas presented in this chapter come from academic studies of market microstructure. Academics, along with many others, have identified the essential forces that structure exchange markets and that ultimately produce market quality characteristics such as liquidity, price efficiency, and volatility.

Some of the more important principles include

• Asymmetric information and adverse selection. Well-informed traders profit from those who are less informed. Dealers in particular lose to well-informed traders and must always consider whether the quoted prices reflect current values. Their quotes must be wide enough that the profits that they earn from trading with utilitarian traders cover the losses that they incur to well-informed traders.

• The zero sum game. Rational profit-motivated traders only trade if they expect to profit. Other traders trade because they obtain other benefits besides trading profits. The most important of these utilitarian traders are investors, borrowers, hedgers, tax avoiders, and asset exchangers. Markets exist only when utilitarian trades are willing to trade.

• Price efficiency. Well informed traders cause prices to reflect information. They profit only because utilitarian traders are willing to trade and accept their losses to informed traders. The interest of utilitarian traders thus ultimately determines who informative prices are. Public disclosure programs increase price efficiency by reducing the costs of research for informed traders. Prices cannot always be efficient. Prices differ from value when values change in response to news but prices have not changed or when prices change in response to trading by uninformed traders but values have not change. These events allow informed traders to profit.

• Liquidity. Trading is the successfully outcome of bilateral searches conducted by buyers and sellers. Exchange systems that reduce the costs of conducting these searches reduce transaction costs. By concentrating order flow to a single price and often to a single point in time, exchange trading systems make it easier for buyer to find sellers and vice versa. Liquidity is the ability to quickly buy or sell substantial size at low cost when you want to trade. Liquidity has many related dimensions, the most important of which are width, depth, and immediacy.

• Order exposure. Large traders and their brokers must be very careful when exposing their orders since large orders give away significant trading options and often tend to move the market. Clever traders who are aware of large orders will front-run them to extract the option values of their orders or to exploit their price impacts. Both activities can significantly increase the costs of trading.

• Rules affect liquidity. Exchanges design their trading systems to provide incentives to traders to offer liquidity. The rules generally reward traders who offer the most aggressive prices, who display their orders, and who arrive early.

• Liquidity costs. The cost of trading depends on the interest of utilitarian traders, the degree of information asymmetries among traders, and the volatility of the underlying instrument.

• Equilibrium bid/ask spreads. The primary decision that traders must make when choosing an order submission strategy is whether to post limit orders and wait for other to come to them or to use marketable orders to trade with those who have posted orders. In general, traders for whom time is valuable or who trade on information that will soon become public take liquidity. Other traders offer liquidity. These decisions are regulated by the cost of liquidity, which bid/ask spread often represent well. When spreads are large, offering liquidity is more attractive. Order submission decisions affect bid/ask spreads. Markets find an equilibrium spread then maximizes the volume of trade.

• Make-or-take pricing. Make-or-take exchange fee pricing distorts quoted equilibrium spreads, but does not change bid/ask spreads net of access fees. Traders who offer liquidity at exchanges that use this pricing system post more aggressive quotes because they receive liquidity rebates. Net pricing must remain the same because spreads must adjust to obtain a balance between traders making and taking liquidity. Otherwise traders would switch from taking to making or vise versa.

• Competition. Dealers, arbitrageurs, public traders, brokers, and exchanges compete to provide and organize liquidity. Their competitions reduce the costs of trading and produce innovative trading systems and products.

• Two competitions. The competition among traders to obtain the best price and the competition among exchange service providers to provide exchange services often are not compatible with each other. Policies that would improve one competition typically harm the other. The pro-competitive position on any issue affecting both competitions—which includes most issues—therefore is rarely unambiguous.

• Access to information and trading systems. Proprietary trading profits for high frequency traders increase with superior access to information and to exchange trading systems. The high prices that for-profit exchanges place on these services effectively allows them to participate in the profits that high frequency traders obtain from their trading. Although these traders profit from utilitarian traders, they also serve them by lowering liquidity costs. The primary losers are traditional dealers who have not created proprietary electronic trading systems.

• Internalization and payments for order flow. Broker-dealers internalize or sell order flow from utilitarian traders to dealers to profit from trading less informative order flow. These processes are particularly profitable when bid/ask spreads are wide at exchanges. Unfortunately, the diversion of utilitarian order flow from exchanges increases bid/ask spreads at exchanges, which makes the process more profitable. Competition among brokers for the customer order flow from which they profit tends return much of the profits to the customers in the form of lower commission and better service. However, competition is never perfect so that brokers undoubtedly benefit from the system.

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